Agent K: Did he say anything to you?
Officer Edwards: Yeah, he said the world was coming to an end.
Agent K: Did he say when?

Men in Black (2001)

Reading the pro-gold submissions incorporated
in the Report of the U.S.
Gold Commission twenty-some years ago is a humbling exercise.
A lot of those old commentaries could have been written today.
They say just what gold bugs say now: our monetary system is
doomed, and its end will be marked by a major monetary crisis.
The concluding chapter of the Minority Report (Volume II, Annex
A) put it thus:[1]

Should Congress not adopt the recommendations outlined above,
we can expect core inflation rates to rise over the next decade,
and at an accelerated rate  so that in ten years from now
we can expect cheering in the media when the inflation rate falls
below 50%. As inflation deepens and accelerates, inflationary
expectations will intensify, and prices will begin to spurt ahead
faster than the money supply. / It will be at that point that
a fateful decision will be made  the same that was made
by Rudolf Havenstein and the German Reichsbank in the early 1920s:
whether to stop or greatly slow down the inflation, or to yield
to public outcries of a shortage of money or a liquidity
crunch (as business called it in the mini-recession of
1966). / In the latter case, the central bank will promise business
or the public that it will issue enough money to enable the money
supply to catch up with prices. When that fateful
event occurs, as it did in Germany in the early 1920s,
prices and money could spiral upward to infinity and it could
cost $10 billion to buy a loaf of bread. America could experience
the veritable holocaust of runaway inflation, a cataclysm which
would make the Depression of the 1930s  let alone
an ordinary recession  seem like a tea party.

Ahem. To state the obvious, the gold bugs
of a generation ago got it wrong. Congress did not adopt their
sound money recommendations, and yet the sky did not fall, the
paper-based system muddled through famously, and in fact it was
gold that entered into a 20 year bear market in dollar terms.

Left unaddressed, this bad call makes it easy
to dismiss the balance of the Minority Report as similarly flawed
or at best irrelevant. Moreover, it implicitly impeaches the
credibility of all sound money advocates even today. After all,
why should anyone pay attention to a bunch of Chicken Littles
whove been demonstrably wrong for a generation? So it behooves
us to address this question, and examine why we didnt slip
into terminal monetary crisis, as predicted, back in the 1980s.

Our inquiry will take us through jargon-infested
waters, so we will take pains to define our terms. We write as
gold bugs, but we will also be guided by the teachings of the
great Austrian economists, principally Ludwig von Mises and Murray
N. Rothbard.

Anatomy of a Hoax

For the naïve mind there is something miraculous in the
issuance of fiat money. A magic word spoken by the government
creates out of nothing a thing which can be exchanged against
any merchandise a man would like to get. How pale is the art
of sorcerers, witches, and conjurors when compared with that
of the governments Treasury Department![2]

To understand how our monetary system was
rescued, we first need to get clear on what that system is.[3] This is not as easy
as it should be. Thats because in substance its just
a government printing press, of the type reflected in the foregoing
quote from Mises. But in form its a holdover from an earlier
time when we had a fractional reserve banking
system with gold as the reserve asset. The structure and terminology
of our current system only make sense in their original context,
where, for all the many problems associated with fractional reserve
banking, there was at least something real at the heart of it.
Given the disconnect between form and substance in our current
system, the enormous confusion that now attends the subject,
even on the part of knowledgeable people, is perfectly understandable.
But it makes a brief review of Fed 101 essential to making sense
of what happened in the 1980s.

The creation of our fiat money, that is, money
issued by decree, or fiat, occurs in two phases.
Phase I is controlled by the Fed, which does two things. First,
it sets the level of non interest-bearing reserves
that banks are required to hold, expressed as a percentage of
their checking deposit base. That percentage is known as the
reserve ratio. Adjusting this ratio up or
down has a massive contractionary or expansionary impact on the
money supply, given the multiplier effect described below, and
for that reason it has been left alone for years at a marginal
rate of 10%. Banks must maintain these reserves either in the
form of Federal Reserve Notes kept on hand (vault cash),
or in the form of balances held in an account at a Federal Reserve
Bank (reserve balances).

Second, the Fed creates the
reserves, and injects them into the banking system. This is where
the gulf between form and substance is most telling, causing
reasonable people to marvel at the brazenness of it all. The
Fed creates reserves out of thin air, in the form of fresh paper
notes (Federal Reserve Notes or dollars)
that it prints up, or in the form of checks written on itself.
It can inject reserves into the banking system in two ways. One
way is to lend them to specific banks, at a rate of interest
known as the discount rate. Reserves borrowed
in this fashion are called, logically enough, borrowed
reserves. This used to be an important tool of monetary
policy, but is rarely used today.

The other way is to buy things, and pay for
them with cash or credit. This is the primary tool today. Whatever
the Fed buys, or monetizes, goes on its balance
sheet as an asset. Whatever it spends, goes on the Feds
balance sheet as a liability, but becomes a reserve asset on
the books of the vendor, or on the books of the vendors
bank, if the vendor itself is not a bank. These transactions
occur either through outright purchases and sales, which have
a relatively long-term impact on the level of reserves in the
system, or, more commonly, through temporary arrangements known
as repurchase agreements, most of which unwind quickly. The Fed
buys things only from a select group of friendly finance contractors,
now 22 in number, known collectively as primary dealers.[4] Some of these primary
dealers are banks themselves; the rest operate through other
member banks. Reserves created by means of these purchase and
sale transactions are known as non-borrowed reserves.

Once the Fed has bought something and paid
for it with reserves thus created out of thin air,
Phase II kicks in. Phase II is controlled by the banks and the
banks customers in what remains in form, despite the ethereal
quality of it all, a fractional reserve banking system. The new
reserve asset, which the vendor bank received in payment from
the Fed, gives the bank the power to begin a process of creating
more new money. The aggregate amount of new money that can be
created is a multiple of the new reserve asset, equal to the
reciprocal of the marginal reserve ratio, today, 10.

To illustrate this process, Rothbard walks
us through it, step by step.[5] Say the Fed buys an asset for $10 from Big Bank One.
That $10 will support another $100 of fresh money in the banking
system in the form of new customer deposit accounts. But the
new $100 doesnt materialize all at once, or on the books
of Big Bank One alone. Instead, it comes into being as the result
of a gradual series of loan transactions that Big Bank One sets
in motion. In what Rothbard calls a ripple effect,
Big Bank One lends out a portion of the $10, namely $9, (1 minus
the reserve requirement, or .9, times $10). That $9 ultimately
gets deposited at Big Bank Two, which is the second stop in the
series. Big Bank Two lends out .9 times the $9, or $8.10,
and so forth, throughout the series. At the end of the series,
the total new money thus created in the form of fresh deposit
accounts is roughly equal to $100. Thus is our money borrowed
into existence.

The same process works in reverse if the Fed,
instead of buying something, sells it. This has the effect of
draining reserves from the banking system, and will result in
a similarly high powered contraction of the money supply.

The Fed buys things from, and sells things
to, its primary dealers in what are known as open market
transactions, so called because the Fed is operating outside
its cloistered walls in the open market. The contact point is
a trading desk set up in the Federal Reserve Bank of New York,
one of the 12 regional Fed branches. The Desk is daily in the
market for U.S. Treasury securities, which comprises one of the
deepest and most liquid markets in the world, with average daily
turnover in the hundreds of billions of dollars. It does so in
order to implement the monetary policy adopted by the Fed
Open Market Committee (the FOMC)
in its monthly meetings, now followed breathlessly, often without
the slightest comprehension, by a host of commentators.

The way Open Market Operations work is at
root quite simple. The Desk and the primary dealers maintain
a market in reserves, the so called Fed funds market.
To increase the supply of reserves in the banking
system, the Desk will buy Treasuries from the primary dealers,
on either a short or a longer term basis, thereby putting fresh
cash in their pockets. If the supply of fresh reserves on offer
from the Fed exceeds the systems demand, as reflected in
the primary dealers appetite, the price of those reserves,
the so-called Fed funds rate, will tend to
go down. Conversely, to decrease reserves in the
banking system, the Desk will in effect bid for reserves by offering
securities from its portfolio. This requires the buying primary
dealers to cough up cash, thereby draining reserves. If the Feds
demand for reserves from the primary dealers exceeds the supply
available, the price of reserves, the Fed funds rate, will tend
to go up.

Note that these simple hydraulics give the
Fed only two things it can focus on in implementing monetary
policy. It can focus on the quantity of reserves
in the system. Or, it can focus on the price of
those reserves, the Fed funds rate. Thats it. If it focuses
on quantity, it will pick a level of reserves its happy
with and stick with it, regardless of ebb and flow of demand
from within the system. If it focuses on price, it will be darting
in and out of the market with countless transactions at the margin
designed to keep the Fed funds rate, rather than the quantity
of reserves in the system, at a desired level.

As to the quantity of money
out in the system, the Fed has direct control over just one thing:
the monetary base, or base money.
This is the sum of Federal Reserve Notes outstanding and reserve
balances, that is, member bank reserve-deposits at Fed banks.
The power to create base money is limited. It does not extend
to the many other permutations of paper that make up the alphabet
soup of the so-called monetary aggregates, the Ms we hear so
much about:[6]

M1, which consists of currency, travelers checks, demand
deposits and other checkable deposits;

M3, which consists of M2 plus large-denomination ($100,000
or more) time deposits; repurchase agreements issued by depository
institutions; Eurodollar deposits, specifically, dollar-denominated
deposits due to nonbank U.S. addresses held at foreign offices
of U.S. banks worldwide and all banking offices in Canada and
the United Kingdom; and institutional money market mutual funds
(funds with initial investments of $50,000 or more); and the
most recent (and arguably the trendiest) entry,

The Feds control over the monetary aggregates
declines as the subscript numbers get bigger. M3, for example,
includes institutional money market funds with a $50,000 minimum
investment. This element of broad money is totally
outside the Feds purview. No reserves need be posted against
any money market funds, let alone those held by big institutions.
Technically, such funds should not be considered fiat money
at all, as they are not immediately convertible into cash. Nevertheless,
they are a prominent component in a monetary aggregate that is
closely identified with Fed policy. Even M1, the narrowest monetary
aggregate, consists principally of things not subject to the
Feds direct control. So when you read breathless Internet
commentary that claims the Fed is ramping up, or chopping, M3,
you know you are in the presence of a misunderstanding.

As to the price of money in
the system, we see that the Fed can directly influence the Fed
funds rate through its open market operations. But this is just
overnight money. How does the Fed funds rate actually influence
the price of money farther out on the yield curve? According
to the Feds website, it just does: it triggers events:

Changes in the federal funds rate trigger a chain of events
that affect other short-term interest rates, foreign exchange
rates, long-term interest rates, the amount of money and credit,
and, ultimately, a range of economic variables, including employment,
output, and prices of goods and services.

Right. Actually, Fed economists and others
have written a lot over the years analyzing the relationship
among the various interest rates in terms of concepts such as
the Liquidity Effect, the Fisher Effect,
etc.[7]
To those of the Austrian persuasion, these sorts of complex ratios
and formulas are presumptively bogus. The real answer is that
somebody has to buy or sell longer dated securities farther out
on the curve in order to bring those other rates into line. If
the market wont do it, the Fed has to, directly or indirectly.
Of late, the Asian central banks have acted as enforcers, freeing
the Fed from the need to bulk up its or its agent banks
balance sheets.[8] We
will see below, in our discussion of interest rates under the
Volcker Fed, how divergent even short term rates can get when
neither the Fed nor its proxies perform this function.

From a technical standpoint, the Achilles
heel of the fiat money creation mechanism is its dependence,
in Phase II, on human action outside the Feds control.
This is the downside of keeping the old pre-fiat form in place.
The Fed can force reserves into the system, because if primary
dealers dont play they dont stay primary dealers.
And the dealers (or their banks, as the case may be) have an
economic incentive to put reserves so injected to work, because
reserves dont pay interest, and thus excess reserves,
or reserves over the minimum required, are undesirable. But it
is still the case that once inside the system, reserves need
to be needed. Banks have to want to lend, and people have to
want to borrow, before the reserves can work their way through
the system and become money. The system is like a shark that
has to keep moving, or it dies. If the Fed sets the table and
nobody shows up, it gets a deflationary contraction that it cannot
influence, let alone control. This is what the Fed confronted
in everybodys favorite oxymoron, the Great Depression,
when, as Rothbard put it:[9]

The Fed tried frantically to inflate after the 1929 crash,
including massive open market purchases and heavy loans to banks.
These attempts succeeded in driving interest rates down, but
they foundered on the rock of massive distrust of the banks.
Furthermore, bank fears of runs as well as bankruptcies by their
borrowers led them to pile up excess reserves in a manner not
seen before or since the 1930s.

Seventy years later, despite the massive substantive
change thats occurred since then, this remains the Feds
nightmare scenario. The more recent experience in Japan following
the collapse of its bubble is a subject of intense scrutiny and
dread at todays Fed.[10] Thats why Fed officials spend so much time
giving speeches telling us theyre in charge and everythings
okay so go ahead and borrow (create) money. Please.

But speeches and spin only go so far. How
do you get people to borrow money into existence if they dont
feel like it? The same way you get people to take anything off
your hands: you price it to sell. Here it is helpful to consider
the nebulous concept of real interest rates, as opposed
to nominal interest rates.[11]

The theoretical concept is often roughly approximated as a
market, or nominal, rate less the expected rate of inflation,
and sometimesafter the factthe real rate is crudely
calculated by subtracting the actual rate of inflation from the
prevailing nominal rate of interest, or market yield. More sophisticated
modelers of expectations usually assume that expected future
rates of inflation are formed by current and/or recent past inflation
rates. There is thus no real rate of interest to be discovered,
there are merely a variety of attempts approximately to measure
it.

If the Fed wants to induce money creation
in Phase II that it thinks would otherwise not occur, it can
offer money at negative real rates, by setting the Fed funds
rate below inflation expectations. This is in fact what it is
doing now. At 1.5%, the Fed funds rate is well below inflation
expectations. Consequently, people are literally being paid to
create money.

But what if people get full, and wont
borrow even if theyre paid to do so? We quote Fed Governor
Ben Bernanke, who has publicly articulated the issue:[12]

Because central banks conventionally conduct monetary policy
by manipulating the short-term nominal interest rate, some observers
have concluded that when that key rate stands at or near zero,
the central bank has "run out of ammunition"--that
is, it no longer has the power to expand aggregate demand and
hence economic activity. It is true that once the policy rate
has been driven down to zero, a central bank can no longer use
its traditional means of stimulating aggregate demand and thus
will be operating in less familiar territory.

Like gold, U.S. dollars have value only to the extent that
they are strictly limited in supply. But the U.S. government
has a technology, called a printing press (or, today, its electronic
equivalent), that allows it to produce as many U.S. dollars as
it wishes at essentially no cost. By increasing the number of
U.S. dollars in circulation, or even by credibly threatening
to do so, the U.S. government can also reduce the value of a
dollar in terms of goods and services, which is equivalent to
raising the prices in dollars of those goods and services. We
conclude that, under a paper-money system, a determined government
can always generate higher spending and hence positive inflation.

The disconnect between form and substance
in the systems architecture is rivaled by the disconnect
between means and ends in the Feds mission.

With only the crude hydraulics of a fractional
reserve system ostensibly at its command, the Fed is charged,
not with maintaining a stable monetary unit, a defensible goal
for a central bank that would be difficult enough (indeed, historically
unprecedented) for a fiat currency, but rather with achieving
maximum employment, sustainable economic growth, and price
stability.[13] Its mission is thus preposterous. But instead of
owning up to the limitations inherent in the Feds architecture,
its officials always play along, pretending to be all knowing
and all powerful. This puts them under rather severe pressure,
and inevitably leads, we submit, to cheating  undisclosed
market intervention in furtherance of otherwise unattainable
policy objectives. But we get ahead of ourselves.

So now, having completed our little refresher
course in fiat money, we can turn to consider what happened to
save the system in the early 1980s.

That Eighties Show

Looking back at the monetary world of 1980
is rather like viewing a Currier & Ives print. It was a simpler
time. The ongoing experiment in fiat money and managed
currencies was only nine years old. The global monetary
system was limited in geographic scope: the Soviet empire was
still a closed system cut off from the West, and China had not
yet begun to recover from its destructive internal upheavals.
A plausible contender for the role of competing reserve currency
was scarcely a gleam in daddys eye.

The U.S. domestic financial system was itself a relic of the
Bretton Woods era. Commercial banks, still separated from investment
banks and still performing traditional banking functions like
lending and intermediation of private savings, were the principal
financial institutions. The Government Sponsored Entities that
today function as sectoral central banks, Fannie Mae and Freddy
Mac, were mere striplings. Fannie Maes first purchase of
a mortgage-backed security was still a year away. The system
was tightly regulated: interest rates paid by financial institutions
were capped, and only certain financial institutions were permitted
to pay interest at all.

Financial technology was primitive. Spreadsheets
were still done by hand inside the Wall Street banks, and Vydec
still vied with Wang in the steno pools in the major law firms.
Andy Krieger, the young derivatives trader dubbed Patient
Zero who in 1987 would single-handedly short the
entire money supply of New Zealand, was still studying
South Asian philosophy.[14] Global OTC derivatives, had they been tracked back
then by the Bank for International Settlements, would have had
an aggregate notional amount of near zero.

The United States was a creditor, not a debtor.
The worlds largest, in fact. The term carry trade
had not been invented, and the Fed would not succeed in turning
the United States into The Greenspan Nation[15] and the world into
a gigantic hedge fund[16] for another 24 years.

But for all its quaintness in todays
terms, the monetary world of 1980 was in grave danger.

The Second Stage of Inflation

Inflation, wrote Mises early in his career,
is a monetary expansion that results in a decline in the exchange
value of money:[17]

In theoretical investigation there is only one meaning that
can rationally be attached to the expression inflation: an increase
in the quantity of money (in the broadest sense of the term,
so as to include fiduciary media as well), that is not offset
by a corresponding increase in the need for money (again in the
broader sense of the term), so that a fall in the objective exchange
value of money must occur.

Later, writing at the height of the German
inflation, Mises described how inflationary psychology creates
a decreased demand for money. This decreased demand is reflected
in higher turnover of money, as people hasten to get out of cash
and into something else. This is probably the closest he ever
came to embracing a concept of velocity:[18]

as the monetary depreciation progresses, it is evident
that the demand for money, that is for the monetary units already
in existence, begins to decline. If the loss a person suffers
becomes greater the longer he holds on to money, he will try
to keep his cash holding as low as possible. The desire of every
individual for cash no longer remains as strong as it was before
the start of the inflation, even if his situation may not have
otherwise changed. As a result, the demand for money throughout
the entire economy, which can be nothing more than the sum of
the demands for money on the part of all individuals in the economy,
goes down.

And some thirty years after that, he described
the three main stages of inflation in a homely metaphor:[19]

Inflation works as long as the housewife thinks: I need
a new frying pan badly. But prices are too high today; I shall
wait until they drop again. It comes to an abrupt end when
people discover that the inflation will continue, that it causes
the rise in prices, and that therefore prices will skyrocket
infinitely. The critical stage begins when the housewife thinks:
I dont need a new frying pan today; I may need one
in a year or two. But Ill buy it today because it will
be much more expensive later. Then the catastrophic end
of the inflation is close. In its last stage the housewife thinks:
I dont need another table; I shall never need one.
But its wiser to buy a table than keep these scraps of
paper that the government calls money, one minute longer.

By the end of the 1970s, we had reached
stage two. The Appendix to the Minority Report contains a number
of charts and tables that graphically depict the gravity of the
situation as seen by contemporary observers. We reproduce a few
below for ease of reference.

The Consumer Price Index had reached worrying
levels.

Source: Minority Report Appendix, Chart 3

Today, the CPI has lost credibility among
knowledgeable observers due to results-oriented adjustments of
its components in defiance of the reality of everyday experience.[20] At the time of the
Gold Commission, however, such measures had not yet fallen into
disrepute. Even Austrian economists conceded that for all their
inherent flaws, price indexes contributed to inflationary psychology:[21]

The index-numbering method is a very crude and imperfect means
of measuring changes occurring in the monetary units
purchasing power. As there are in the field of social affairs
no constant relations between magnitudes, no measurement is possible
and economics can never become quantitative. But the index-number
method, notwithstanding its inadequacy, plays an important role
in the process which in the course of an inflationary movement
makes the people inflation-conscious.

People were indeed becoming inflation-conscious.
Contracts routinely contained inflation adjustment clauses, and
housewives were beginning to buy that frying pan sooner rather
than later.

The bounty needed to induce people to hold
dollar-denominated assets was skyrocketing, at both ends of the
yield curve. Long term nominal interest rates were stratospheric,
reflecting utter destruction in the bond market.

Source: Minority Report Appendix, Chart 9

Short term rates were climbing too.

Source: Minority Report Appendix, Chart 5

It did not help matters that real
interest rates, given the high price inflation, were actually
low or negative for much of the 1970s. Rates were still
shocking, and the high rates were emblematic of systemic distress.

Ominously, the fiat monetary system had already
lost several pitched battles in its war with gold. Lacking todays
price management technology, the U.S. and European monetary authorities
had been forced to attempt to quell the gold price by means of
open sales of physical metal throughout the preceding 18 years.
The London Gold Pool of the 1960s had broken down in abject
failure in March 1968, leading to the abrogation of the Bretton
Woods gold exchange monetary system three years later. The U.S.
Treasury gold sales of the 1970s ended in 1979, and the
last of the parallel sales by the International Monetary Fund
occurred on May 7, 1980.

Like interest rates, and despite the best
efforts of the monetary authorities, the gold price was soaring,
hitting $850 in the afternoon London fix on January 15, 1980.
The false premise at the core of the fiat monetary system, the
conceit that paper printed by a government bureau is money and
that gold is not, was being exposed for all to see.

Source: Minority Report Appendix, Chart 1

Public confidence, the essential support for
fiat money, was at risk. The memory of gold as money had not
yet been fully extinguished, as reflected in the very fact that
shortly thereafter a Congressional Commission was established
to study the issue. Moreover, the next President of the United
States, who had popularized the term misery index
during the election campaign, was himself a closet gold bug:[22]

Like the supply siders in congress, Reagan privately advocated
restoration of the gold standard as the ultimate way of guaranteeing
stable money. You cant control inflation as long
as you have fiat money, he told his aides. The Presidents
attachment to gold was almost never mentioned in public, however.
His political advisers feared that it would sound kooky
and old-fashioned to voters.

The very structure of the system was eroding.
Membership in the Federal Reserve System was at that time elective
for banks operating under state, rather than federal charters.
Fed membership was expensive: member banks had to comply with
the reserve ratio, and tie up funds in reserve assets that paid
no interest. So new banks were being formed under state statutes,
and existing members were quitting the Federal Reserve System
altogether, switching their charters from federal to state and
opting out of the Feds burdensome regulatory scheme.[23] The power of the
central bank, the linchpin of the fiat monetary system, was waning.

Something had to be done. There was still
time to avert a stage three inflation, but there was no time
to lose.

The Making of a Legend: Volcker
the Monetarist

On August 6, 1979, Paul Adolph Volcker, a
tall, cigar-smoking ascetic, had become Chairman of the Fed,
replacing mid-term the hapless G. William Miller. In Volcker,
one of its original architects, the fiat monetary system had
finally found the perfect champion:[24]

Volcker was a public servant who had served the government
in both capitals, Washington and Wall Street. He was a policy
maker under four Republican and Democratic Presidents and had
spent years on Capitol Hill fencing with congressional committees
and lobbying for votes. He was in Treasury when John F. Kennedy
proposed the stimulative tax cuts of the early 1960s and when
Lyndon Johnson launched the U.S. war in Indochina. Under Nixon,
he worked closely with Treasury Secretary John Connally, an urbane
Texas politician who frequently complained about Volckers
dowdy appearance. (Connally once threatened to fire him if Volcker
did not get a haircut and buy a new suit.) / Together, Connally
and Volcker engineered the most fundamental change in the worlds
monetary system since World War II  the dismantling of
the Bretton Woods agreement that had made the U.S. dollar the
stable bench mark for all currencies.

Actually, the foregoing passage likely understates
Volckers role in killing Bretton Woods, as his boss, the
only U.S. Treasury Secretary ever to declare personal bankruptcy,
was not noted for his mastery of monetary arcana.

According to legend, once installed as Chairman,
Volcker quickly sized up the situation and reoriented monetary
policy to focus on the quantity of money, rather
than its price. This famous policy shift was announced
to the world in the October 6 Record of Policy Actions of the
FOMC, which heralded:[25]

...a shift in the conduct of open market operations to an
approach placing emphasis on supplying the volume of bank reserves
estimated to be consistent with the desired rates of growth in
monetary aggregates, while permitting much greater fluctuations
in the federal funds rate than before.

The reserve targeting procedure from 1979 to 1982 gradually
came to provide assurance to financial markets and the public
at large that the Federal Reserve would not underwrite a continuation
of high and accelerating inflation. Reinforcing this procedures
built-in effects on money market conditions were judgmental changes
in nonborrowed reserve objectives and in the discount rate. Monetary
policy contributed importantly to lowering the inflation rate
sharply, albeit not without a significant increase in interest
rate volatility and a period of marked decline in output.

It is easy to see why it is in the interest
of the Fed to embrace the Volcker legend. For its moral is that
the all-knowing, all-seeing Fed, reluctantly but sternly facing
down a crisis, did what it had to do to kill inflation. It had
the power, it had the knowledge, and, with the right person in
charge, it had the will. If things ever get out of hand again
 not that theyd ever tolerate that, mind you 
theyd do the same thing, and whip inflations sorry
backside once more.

Volckers monetary policy was dubbed
monetarism by a media unschooled in monetary theory.
True monetarists, like Keynsians, accept the legitimacy of a
fiat monetary system. But unlike Keynsians, they believe there
must be a strict, rule-based method of gradually and consistently
increasing the money supply, in contradistinction to the herky-jerky
instincts of the modern Fed. The Gold Commission contained a
number of monetarists, and their influence is evident in the
Majority Report. But the Feds monetary statistics plainly
show that while Chairman Volcker was no doubt many things, a
monetarist he was not.

The Quantity of Money under the
Volcker Fed

Consistent with legend, the Volcker Fed during
its so-called monetarist period was indeed rather stingy with
the supply of non-borrowed reserves to the system.

Source: Federal Reserve

It should be noted, however, that even during
its stingy phase, the Volcker Fed made sure to enhance the systems
back door access to borrowed reserves, just in case. It did this
by means of discount rates that were generally set at significantly
lower levels than Fed funds rates. See table entitled Key
Interest Rates during the Volcker Fed in the following
section.

In any event, the stinginess was short-lived.
Things changed dramatically in July 1982. From that point on,
the Fed put the hammer to the floor and inaugurated what would
become its standard response thereafter to any perceived systemic
threat: extremely aggressive monetary expansion. The specific
catalyst for this was the failure on July 6, 1982, of a reckless
little bank in Oklahoma known as Penn Square.[27] Penn Squares
paper was widely held by a number of important money center banks
whose failure in turn was not an attractive prospect to the monetary
authorities. A more general catalyst was the imminent sovereign
default of Mexico.

Over the next five years, non-borrowed reserves
(NBR) expanded at a heroic rate, roughly doubling
the levels at the beginning of the Volcker Fed. By way of comparison,
over the eight year period commencing August 1971, that is to
say, during the inflationary hurricane preceding Volcker, Seasonally
Adjusted NBR only increased from 14,380 to 18,923, and Not Seasonally
Adjusted NBR only increased from 14,094 to 18,612. By way of
further comparison, over the eight year period commencing August
1987, that is to say, during the warmup phase of the Greenspan
Fed, Seasonally Adjusted NBR only increased from 38,651 to 57,326,
and Not Seasonally Adjusted NBR only increased 38,412 to 56,655.
The Maestro, no slouch himself in the monetary reserve creation
department, was a piker in comparison to post-Penn Square Volcker.

The vaunted monetary aggregates followed suit. As with the reserve
levels themselves, in the pre-Penn Square period, the increases
in the money stock, while hardly hairshirt material, were modest
in comparison to the carnival that followed.[28]

Source: Federal Reserve

The Monetary Base under the Volcker
Fed

An important plank in the monetarist critique
of the Volcker Fed is the erratic behavior of the monetary base,
the only monetary aggregate that the Fed can directly control.
The basic charge is that rather than focus on what it could control,
the Volcker Fed focused on what it couldnt, namely the
other monetary aggregates. The following table shows the rate
of increase in the monetary base for the periods indicated. By
comparison, the rate of change in the monetary base in the year
leading up to Volckers appointment was 7.2%.

Source: Monetary Trends, Federal Reserve Bank
of St. Louis, September 1983, cited in Richard Timberlake, Monetary
Policy in the United States (University of Chicago Press,
1993), p. 359.

Indeed, Richard Timberlake marshals the foregoing
data to support his charge that Volckers Fed, far from
being monetarist in its policies, was just another Fed, ramping
up the money supply to aid an incumbent president in an election
year, and choking back once the results were in.[29]

Prior to the presidential election of 1980, Fed policy had
been highly stimulative in the face of manifest inflation. This
experience, as well as the Feds performance in earlier
presidential elections, inspired observers to rename the FOMC
the Committee to Reelect the President. The Record
of Policy Actions of the FOMC never mentioned the retention of
the incumbent president as a goal of policy. Nonetheless,
most of the Reserve Board members in any given election year
owed their appointments to the incumbent and had every incentive
to play ball. The Feds performances just before,
during, and just after elections in 1960, 1964, 1968, 1972, 1976,
and 1980 seemed to be clearcut examples of a pattern that was
restrictive and then stimulative during the year before the election,
and then usually restrictive enough to slow down the inflationary
reaction after the election.

And the wide swings in the monetary base were
clearly inconsistent with monetarist doctrine, which prescribed
a gentle and systematic reduction in the rate of increase
in the monetary base until the growth rates of the money stocks,
observed as indicators, came down to noninflationary values.[30]

Having said that, in fairness it is not clear
that what was happening to the monetary base was entirely within
the Feds control. The problem is that, as Rothbard points
out,[31] the
two constituents of the monetary base, cash and reserves, move
in opposite directions. That is, cash in circulation represents
reduced reserves: once outside the banks, it no longer counts
as a reserve asset, and loses its multiplier. If people decide
to pull money out of their bank accounts and hold it in the form
of cash as opposed to leaving it in the form of abstract deposits
on the banks books, this depletes reserves, turning high
powered money into chump change and initiating a rippling contractionary
process. So adjustments must be made at the bank: aggregate deposits
must shrink or reserves must be replenished through Open Market
Operations. The contradictions inherent in our fiat money, the
spawn of a beast with the brain of a printing press and the body
of a fractional reserve banking system, are not to be reconciled
simply by focusing on the right monetary aggregate.

The Price of Money under the Volcker
Fed

For all the talk of quantity, under the Volcker
Fed the real action was in price. The Fed essentially stood aside
and let short rates rip; the monetarist mumbo jumbo provided
intellectual cover:[32]

Throughout Volckers anti-inflation campaign, the nation
was instructed by the Fed to watch M-1 and the monetary aggregates
as the correct gauge of its monetary policy. But the monetary
numbers zig-zagged up and down in a bewildering manner that confused
even the economists. The public and the politicians would have
had a far more accurate sense of what was happening if they had
ignored M-1 and simply followed interest rates and their relative
levels. Except for two brief periods in the summer months of
1980 and the last quarter of 1981, the Federal Reserve had succeeded
in holding most short-term interest rates above long-term rates
for an extraordinary length of time  two and one half years.
This abnormality explained things far more reliably than what
was happening to M-1 growth or the other aggregates.

Interestingly, the average annual Fed funds
rate was actually higher than the one year Treasury rate throughout
Volckers tenure. Take note, convergence theorists.

Source: Federal Reserve

The Demand for Money under the
Volcker Fed

But more important than changes in the supply
or even in the price of money under the Volcker Fed was a pronounced
increase in the demand for money.

Volcker himself, sounding like an Austrian
economist, put his finger on the demand issue in 1983: Individuals
and businesses apparently desired to hold more money than usual
relative to incomes.[33]

This increase in demand left tracks in statistics
generated by a mainstream mathematical formula known as velocity.
Velocity is a term used to express the concept of turnover of
units of money in relation to broader measures of economic activity,
like GNP. As such, it is one of those equations without meaning
for Austrian economists. Indeed, Mises specifically rejected
velocity as a top-down explanatory formula:[34]

The mathematical economists refuse to start from the various
individuals demand for and supply of money. They introduce
instead the spurious notion of velocity of circulation fashioned
according to the patterns of mechanics.

Mises grudgingly acknowledged the possibility
of using velocity as a record of bottom-up behavior, however:[35]

If there is any sense in such notions as volume of trade and
velocity of circulation, then they refer to the resultant of
the individuals' actions. It is not permissible to resort to
these notions in order to explain the actions of the individuals.

We propose to seize that opening. The following
table shows how, after increasing steadily for 35 years, velocity
of M1 suddenly fell off a cliff.

What the Feds chart appears to signify
is that instead of trying to get rid of their depreciating cash,
people were holding on to it. This behavior is the exact opposite
of that associated with inflation, and the Feds chart,
viewed merely as an historical record, neatly captures the breaking
of the fever. It doesnt explain why the housewife was no
longer so anxious to swap out of her cash to get that frying
pan, it just reflects the fact that this was happening.

Back in 1914, Mises defined deflation as the
converse of inflation:[36]

Again, deflation (or restriction, or contraction) signifies
a diminution of the quantity of money (in the broader sense)
which is not offset by a corresponding diminution of the demand
for money (in the broader sense), so that an increase in the
objective exchange value of money must occur.

This definition does not appear to encompass
a demand-driven deflation occurring within the context of a credit
expansion, that is, a situation in which an increase in the quantity
of money is insufficient to satisfy a disproportionate increase
in the demand for money. So it is with some trepidation that
we observe that such a micro-deflation is precisely what appears
to have occurred under the Volcker Fed. The associated decline
in the rate of increase in price levels is what mainstream economists
refer to when they use the term disinflation.

The resultant increase in the objective exchange
value of money found expression in a steep decline in the rate
of increase in prices tracked by the various indexes.

Source: Federal Reserve Bank of St. Louis

The increased demand for money was also reflected
in a marked increase in its price in real terms. Notwithstanding
the decline in nominal rates under the Volcker Fed as shown in
a previous table, real interest rates reached levels seen only
once before in the Twentieth Century, during the Great Depression.
[37]

Auf Wiedersehen, Inflation

A similar decline in velocity had marked the
monetary stabilization that followed the storied German inflation
some 60 years earlier. This was the catastrophic, stage three
inflation mentioned in the initial excerpt from the Minority
Report.

Costatino Bresciani-Turroni, a first hand
observer of the German inflation who later wrote the definitive
treatment of the subject, describes what Austrian economists
refer to as the crack-up boom that was unfolding
by August 1923:[38]

In the autumn of 1923 the monetary situation was as follows:
There was a great quantity of paper marks, whose nominal value
increased at a fantastic rate, but which in reality, despite
the great increase in the velocity of the circulation, were sufficient
only for a part of the transactions in German internal business.
In the total circulation legal money now only played a secondary
part, and the need of a circulating medium was largely satisfied
by emergency means of payment, or by illegal currencies.

The reduced role of the legal issue created
the necessary conditions for monetary reform, a process that
took place roughly from August through November 1923. The reform
involved the introduction of new types of money. These were all
conjurors tricks, unbacked paper experiments issued in
great quantity and announced with great fanfare as money
with a stable value. The first of the new money issued
was in the form of Gold Treasury Bonds and notes
backed by a Gold Loan, issued principally at the
provincial and town level. Bresciani-Turroni describes them thus:[39]

It is unnecessary to state that the guarantee of the so-called
money with a stable value was purely fictitious.
Actually the Gold Loan and the Gold Treasury Bonds were mere
paper without any cover. / Indeed, the law of August 14th, 1923,
on the Gold Loan of 500 million gold marks, contained only this
limited promise: In order to guarantee the payment of interest
and the redemption of the loan of 500 million gold marks, the
Government of the Reich is authorized, if the ordinary receipts
do not provide sufficient cover, to raise supplements to the
tax on capital, in accordance with detailed regulations to be
determined later. These vague words constituted the entire
guarantee behind the Gold Loan! Nevertheless, the Gold Loan Bonds
and the notes issued against the Gold Loan deposits did not depreciate
in value. The public allowed itself to be hypnotized by the word
wertbestandig (Stable-value) written on the new paper
money. And the public accordingly accepted and hoarded these
notes (the Gold Loan Bonds almost disappeared from circulation)
even whilst it rejected the old paper markpreferring not
to trade rather than receive a currency in which it had lost
all faith.

The most famous of these expedients was the
Rentenmark, which was authorized in October and introduced into
circulation in November 1923. Its introduction was not accompanied
by the recall of any of the existing legal money in circulation,
and its enabling decree expressly authorized issuance in the
amount of 2.4 billion, or approximately ten times the aggregate
real value of legal money then in circulation. Despite this,
and largely for psychological reasons, it was a smashing success:[40]

In October and in the first half of November lack of confidence
in the German legal currency was such that, as Luther wrote,
any piece of paper, however problematical its guarantee,
on which was written constant value was accepted
more willingly than the paper mark. If the Government had
been able to suspend the issues of paper money for the State,
probably confidence in the mark would have revived, as had happened
in the case of the Austrian crown, and as occurred later with
the Hungarian crown. But think what would have been the psychological
effect of the Government announcing that it would issue more
paper marks to about ten times the value of the total amount
of paper circulating on November 15th, 1923! No one would have
had any faith in the promise of the Government that later the
issues would be stopped. The precipitous depreciation of the
paper mark would have continued. But on the basis of the simple
fact that the new paper money had a different name from the old,
the public thought it was something different from the paper
mark, believed in the efficacy of the mortgage guarantee and
had confidence. The new money was accepted, despite the fact
it was an inconvertible paper currency. It was held and not spent
rapidly, as had happened in the last months with the paper mark.

Bresciani-Turroni explicitly describes the
success of the Rentenmark in terms of lower velocity:[41]

It is not difficult to explain why the monetary reform had
been accompanied not by a contraction but by an
actual increase in the quantity of legal money
in circulation. The lack of confidence in the paper mark being
lessened, consumers, producers, and merchants ceased to be pre-occupied
with the necessity of reducing their holdings of paper marks
to the minimum. In other words, the velocity of circulation
of paper marks declined. That helped to create the need
for a new circulating medium, so that new paper marks could be
issued within the limits of this need, without imperiling the
stability of the exchange. [Emphasis in original.]

In the United States of the early 1980s,
the earlier stage inflation had not run its course to currency
collapse. No new currency had been introduced. No grand plan
had been implemented. The fiat monetary spigots were opened wide
after a few short years of relative restraint, and the Fed explicitly
repudiated its tight money policies in October 1982.[42] So the question remains,
what accounted for this increase in the demand for fiat money?

The answer appears to reside principally in
two key factors identified by Richard Timberlake: deregulation,
brought about by legislated structural change, and the internationalization
of the U.S. currency.[43]

Let us consider these in turn.

DIDMCA: Not Just Another Pretty
Name

If youve never read the provisions of
the Depository Institutions Deregulation and Monetary Control
Act of 1980, youre not alone. Congress never read it either.

Source: Federal Reserve Bank of Boston

This was a complex statute that had two important
Titles: Title I, which strengthened the Fed, and Title II, which
deregulated interest rates.

The monetary control provisions of Title I
strengthened the Fed in two ways. First, they pulled the entire
U.S. banking system under its control. All depository institutions,
not just member banks, were now subject to reserve requirements
set by the Fed. Second, they expanded the list of eligible
collateral for the Feds Open Market operations to
include assets, such as foreign securities, that were previously
not eligible for purchase. In the context of the implementation
of conventional monetary policy, the notion of eligible
collateral is meaningless, since fiat money is legal tender,
and requires no collateral in any event. The practical import
of this expansion of authority is that the Fed could now pretty
much monetize anything it wanted, including, according to an
unnamed senior Fed official quoted in a 2002 Financial Times
(London) article, gold mines.[44] The structural import, according to Timberlake, is
that the Fed achieved its ambition of becoming an imperial central
bank:[45]

Nothing in Volckers statements or letters substantiates
either the technical or operational necessity for the extended
collateral provisions. What, then, could have been the real reason
for Volcker to have insisted that Congress extend the Feds
money-creating hegemony if the Fed already had infinite control
over the U.S. money supply? / The only answer seems to be that
the Fed as an agency of the U.S. government was designing itself
to become the international financial arm of the Executive Branch.
/ Very few congressmen who voted for the DIDMCA of 1980 realized
the additional powers that the act granted the Federal Reserve
System in its quest to provide itself with imperial financial
control.

But our present focus is on the deregulation,
rather than the monetary control, provisions of the DIDMCA. These
permitted all depository institutions to pay interest
on checkbook balances of demand deposits. They also phased out
Regulation Q, which had allowed the Fed to limit the amount of
interest paid on time deposits.

The impact of this deregulation was immense.
Now, for the first time, fiat checkbook money paid interest.
This, and not the Feds jiggery-pokery on monetary policy,
was the key to breaking the fever. That giant sucking sound throughout
the 1980s was the flood of wealth into deposit accounts.

The disinflation of 1982-1986 was both an unanticipated bonanza
and a self-reinforcing phenomenon. No one foresaw the reduction
in the velocity of money that would result from the institutional
changes that took place. The reinforcing element was the deflationary
effect on interest rates that accompanied the general price level
disinflation.

Fiat Goes Global

The interest rate deregulation under Title
II was not the only factor feeding the demand for fiat money,
however. Another, also outside the purview of Fed policy, was
the growing use of the greenback as a currency outside the United
States. Timberlake describes the process:[47]

As the value of the dollar tended to stabilize during the
first half of the 1980s, foreign business firms and households
increased their demand for Federal Reserve notes for use in their
day-to-day transactions. Many third world central banks and government
treasuries were at the same time devastating their local economies
with hyperinflationary issues of paper currency, so many of the
inflation-bedeviled peoples began to use U.S. currency. While
the dollar had not stabilized at a zero inflation rate, it was
far superior as a store of value to most of the other major currencies
around the globe. A few other currencies, such as the Swiss franc,
were closer to absolute stability than the dollar; but none had
the combination of stability and volumetric availability that
the dollar possessed.

The precise impact of this phenomenon is difficult
to measure because the Fed can only guess how much of its notes
in circulation are actually circulating abroad. They do know
that its a big number. The Fed's estimate as of the end
of 1995 was that of the $375 billion then circulating outside
the banks, between $200 and $250 billion, or well over half,
was held outside the United States.[48]

Aside from representing a significant benefit
for the United States -- currency used abroad being equivalent
to an interest free loan to the home team -- the internationalization
of U.S. currency obviously makes difficult the measurement of
even the narrowest monetary aggregate, for purposes of implementing
domestic monetary policy.

Another Lucky Break

Deregulation and internationalization were
the primary factors behind the decline in velocity. But a further
contribution to an increase in the objective exchange value of
fiat money came from left field, namely, a crack in the overheated
commodity markets. Indeed, Mark Faber gives this factor pride
of place:[49]

This very tight monetary policy implemented by Paul Volcker
is usually credited for having brought down the rate of inflation
after 1980. However, it is my view that the rate of inflation
would have come down regardless of monetary policies because
strong price increases for all commodities between 1965 and 1980
had led to additional supplies, which after 1980 began to flood
the market and depress prices. This was particularly true for
oil, which had risen in price from $1.70 per barrel in 1970 to
close to $50 per barrel in 1980. In addition, conservation efforts
all over the world had curtailed demand.

Questions for Extra Credit

So we see how an increase in the demand for
fiat money, brought about by a confluence of monetary policy,
deregulation and market expansion, importantly aided by a collapse
in commodity prices, proved sufficient to save the system in
the 1980s. The gold bugs were right; Havensteins
choice could not be ducked. What they didn't know was that it
had in fact been made, largely by accident, and that the system
had managed to stumble through Door Number One.

Our immediate inquiry is therefore concluded.
Two related questions remain, however. We will touch on them
only briefly, as they bring us in contact with the subject matter
of numerous current commentaries, posted here and elsewhere.

The first question is: what explains the extraordinary
longevity of the preference for paper, a move that has now lasted
a generation. After all, as Timberlake points out (id.):

This series of reinforcing events, nonetheless, was limited;
it could not continue forever unless the Fed constantly reduced
the rate of increase in money growth, or developed new "institutional"
factors that would stimulate U.S. and world demand to hold U.S.
dollars.

The effects of interest rate deregulation
had pretty well worked their way into the system by August 7,
1987, when Alan Greenspan was anointed Fed Chairman. It hardly
bears mention that the Greenspan Fed has not constantly
reduced the rate of increase in monetary growth. To the contrary,
the Greenspan Fed has been directly responsible for the greatest
monetary and credit expansion in the history of the world. What,
then, are these new "institutional" factors that kept
the party going?

They are the much-discussed fruit of the dramatic
changes that have transformed the global financial system over
the last 25 years, making the early 1980's more distant to us
in practical terms than Weimar Germany was to the members of
the Gold Commission. Not all are the Fed's doing. For example,
it presided over (or, perhaps more accurately, adapted to) rather
than directly instigated, the transformation of the global trading
system into a giant vendor finance scheme in which the United
States is permitted to borrow itself into oblivion for so long
as foreign producers are prepared to accept payment in dollars
and recycle them into dollar denominated assets.[50] In the case of others, its role was, to a greater
or lesser degree, more direct. These include the rise of the
capital markets and the decline of the traditional banking function;
the triumph of derivatives and the relative decline in importance
of underlying assets; the rise of huge pools of speculative capital
able to drain or swamp markets with the click of a keystroke;
the transformation of banks into a species of leveraged speculator;
the mountain of debt and derivatives that now menaces the financial
landscape; the proliferation of money substitutes that diminish
further the control of the Fed over the money supply;and the transformation of the Fed itself from
regulator to enabler in the destabilization of markets and the
expansion of financial risk.[51]

Still another "institutional" factor,
one integrally related to the foregoing structural changes, is
official sector cheating: undisclosed, direct or indirect intervention
in financial and commodity markets undertaken to alter market
appearances and influence the behavior of market participants.
It is difficult to quantify, and virtually impossible to prove.
It is even difficult to define. In a system in which even the
financial exposures of a private hedge fund are effectively socialized,
where does the "market" stop, and the Fed begin?[52] Wherever the line
is drawn, we submit that it is not possible to understand how
the demand for dollar assets has been sustained since 1987 without
reference to such activity.[53]

The ultimate rationalization for the market
manipulation, that it is done in order to stave off the collapse
of the dollar system and our privileged position within it, is
no doubt seen by those involved as worthy; indeed, a patriotic
calling that sanctions their enrichment. Those to whom the ends
justify the means, a category which, truth to tell, probably
includes most of us when our financial well being is at stake,
might be inclined therefore to give the Fed and its agents a
pass. After all, the Fed's mandate is interventionist on its
face, the Fed's very existence is an affront to the Constitution;
having swallowed the elephant, why should we now choke on the
gnat? Perhaps this inclination, and not just fear of negative
career consequences, can explain why so few will acknowledge
the obvious. In any event, the dispensation is not ours to give.
In the end, as Mises teaches in an oft-quoted passage, the market
will have its way:[54]

There is no means of avoiding the final collapse of a boom
brought about by credit expansion. The alternative is only whether
the crisis should come sooner as the result of voluntary abandonment
of further credit expansion, or later as a final and total catastrophe
of the currency system involved.

The second and closely related question is:
why are gold bugs still singing the same tired refrain? The Fed
cheated the hangman in the 1980's; why can't it just keep doing
it, wrong-footing those gloomy Guses in perpetuity?

In this essay, we have attempted to lay out
in some detail the confluence of factors that came together to
save the system in the 1980s. We think it clear from this
exercise that this was a one-off event, an historical accident
that could not be repeated even if there were an identical threat,
a common understanding of the nature of that threat, and the
political will to implement a solution. Which of the indicated
policy precedents would be open to us, even if we could satisfy
the foregoing conditions? Deregulate? Clearly not; been there,
done that. Hike rates to historic highs in real terms? No way.
We gambol in the shadow of Debt Mountain. If the Fed were to
raise the Fed funds rate even to within spitting distance of
a positive real rate of interest, it would risk an avalanche
of defaults, threatening economic and political upheaval. Expand
the market for dollars? Get real. Just how do you expand a saturated
market? The challenge now is rather to ward off blowback of the
big foreign dollar float. How about rigging commodity prices?
Now were getting somewhere. Trouble is, we cant rig
them all, and we cant keep it up forever, even for the
ones we can rig. Sooner or later, the law of supply
and demand in the marketplace for real things will trump the
price management effected in the markets for paper derivatives.

No, the die is cast: we shall have the catastrophe.
Our fiat monetary system got a reprieve in the 1980's, not a
deliverance. All that has happened since, with the fantastic
mispricing of credit the Greenspan Fed has engineered, and the
massive global malinvestment this has engendered, is that the
dimensions of the unraveling have become more dire.

Certainly, the banks would be able to postpone the collapse;
but nevertheless, as has been shown, the moment must eventually
come when no further extension of the circulation of fiduciary
media is possible. Then the catastrophe occurs, and its consequences
are the worse and the reaction against the bull tendency of the
market the stronger, the longer the period during which the rate
of interest on loans has been below the natural rate of interest
and the greater the extent to which roundabout processes of production
that are not justified by the state of the capital market have
been adopted.

With respect to the form the denouement will
take, much has been written within the gold community on the
subject of whether we face hyperinflation or deflationary depression
as the prelude to monetary collapse. Both sides of the debate
appear to accept the premise that whatever may transpire will
bear a linear relationship to what now exists. The disagreement
centers on the direction the line will go. But today's markets
are fully linked by derivatives and technology, and they are
patrolled by wolf packs of large, leveraged speculators not noted
for their patient outlook. So it seems likely that the terminal
monetary crisis will unfold on virtually an instantaneous and
discontinuous basis, once the fog of statistical deceit and false
market cues begins to lift and a clear trend either way becomes
evident. We are not likely to enjoy the luxury of observing either
a deflation or an inflation unfold in the fullness of time, but
rather, just as Mises foretold, a final and total catastrophe
of our fiat monetary system. All we can hope is that once the
curtain falls on the current system, the wisdom in the gold bugs'
submissions to the Gold Commission will finally find a receptive
audience.

3. Sean Corrigan of Sage Capital,
a practicing Austrian, has expressed doubts whether the traditional
formulation of the Feds role in the creation of money applies
under todays institutional circumstances. He notes, among
other things, that bidding for reserves occurs on a post-hoc
basis; that is, banks do their lending and borrowing, and work
out over the course of the two week maintenance period what they
need in reserves and then go bid for the balance retrospectively,
and that banks today are more on a BIS-style capital standard
than subject to meaningful reserve restraints. Fair point. As
a result of the structural changes that have occurred in the
system since 1980, noted later in this essay, the practical significance
of the reserve creation activity summarized below has been radically
diminished, even though there remains a tacit agreement among
the Fed, market participants and commentators to continue the
pretence. As James Grant points out in the April 9, 2004, edition
of Grants Interest Rate Observer, less than 4% of
the broadly defined money supply is now subject to reserve requirements.
However, as our focus is the early 1980s, before deregulation
and technology had wrested control over the creation of money
from the monetary authorities, we rationalize that current theory
is at least reasonably consonant with early 1980s practice.

8. This phenomenon is discussed
in detail in the April 9, 2004, edition of Grants Interest
Rate Observer.

9. Rothbard, op. cit., p.
145.

10. See, e.g., Board of
Governors of the Federal Reserve System, International Finance
Discussion Papers, No. 729, June 2002, Preventing Deflation:
Lessons from Japan's Experience in the 1990s (www.federalreserve.gov/pubs/ifdp/2002/729/default.htm).
In concluding that ...when inflation and interest rates
have fallen close to zero, and the risk of deflation is high,
stimulus -- both monetary and fiscal -- should go beyond the
levels conventionally implied by baseline forecasts of future
inflation and economic activity, this paper amplified the
January FOMC discussion cited in note 10 and prefigured Governor
Bernakes November remarks cited in the same note.

Governor Bernanke was not just out on a frolic of his own.
See also the (heavily redacted; full minutes are not released
until five years after the event) Minutes of the FOMC, January
29-30, 2002, in which the following curious passage appears:

At this meeting, members discussed staff background analyses
of the implications for the conduct of monetary policy if the
economy were to deteriorate substantially in a period when nominal
short-term interest rates were already at very low levels. Under
such conditions, while unconventional policy measures might be
available, their efficacy was uncertain, and it might be impossible
to ease monetary policy sufficiently through the usual interest
rate process to achieve System objectives.

A March 25, 2002 Financial Times article by Peronet Despeignes
quoted an unnamed senior Fed official who attended the meeting
as stating that the term unconventional means was
commonly understood by academics, and that the Fed
could theoretically buy anything to pump money into the
system, including state and local debt, real estate
and gold minesany asset.

It does not appear that this purchase of any asset
can be reconciled with the Feds statutory authority. Perhaps
that is why the senior official in the FT article
chose to remain nameless, and no such specific brainstorming
can be found in Governor Bernankes remarks.

44. See Note 10. DIDMCA did not
in fact authorize the purchase of real estate and gold mines,
but the quote attributed to the senior Fed official,
if true, would indicate that the FOMC doesnt know it.

51. A number of these structural
changes are discussed in Peter Warburton, Debt & Delusion
(Penguin Press, 1999), recently reviewed by Robert Blumen at
http://mises.org/fullstory.aspx?control=1579.
A most lucid treatment of the debt issue may be found in Jonathan
Laing, Debt Bomb, Barrons, January 23,
2003. Doug Noland of PrudentBear.com discusses the decline
in significance of the traditional monetary aggregates in The
Fragile Stability of Monetary Disorder, http://64.29.208.119/creditbubblebulletin.asp.

52. The New York Fed orchestrated,
but did not directly fund, the bailout of Long Term Capital Management.
See Roger Lowenstein, When Genius Failed (Fourth Estate/HarperCollins,
2001). For market participants whose livelihoods depend on correct
assessments of how far they can push the house in the game of
moral hazard it was a distinction without a difference.

53. It is worth recalling what appears
to be the origin of the contemporary stripe of market intervention.
Fittingly, it remains ambiguous as to whence directed and how
effected, and thus where the line between official and private
action can be drawn. The setting was the October 1987 crash.
Sometime after 11:20 on the morning of October 20, just when
all seemed lost, the Major Market Index, an obscure stock index
futures contract on the Chicago Mercantile Exchange, suddenly
soared heavenward. Tim Metz, the reporter who covered the Crash
of 1987 for The Wall Street Journal and later expanded
his reportage in Black Monday (Dow Jones, 1988) described
it as follows (pp. 217-218):

So while the MMI contract price hurtles skyward during the
next ten minutes, most investors-even the pros-won't even notice.
Nobody really believes that a rally produced by purchases of
just over 800 MMI stock index futures contracts in Chicago means
the end of the Stock Market Crash of 1987.

In what may be the last time a Dow Jones publication would
give voice to a financial market conspiracy theory,
Metz attributed what happened to human intervention (p.210):

To me, those facts strongly suggest that only a broadly coordinated
manipulation of stock and futures markets information and prices
averted a stock market plunge on October 20 that could have rivaled,
or even exceeded, that of the day before. Bluntly stated, the
question these facts forcefully raises is whether some leaders
and market makers at the New York Stock Exchange and the Chicago
Mercantile Exchange collaborated to save the stock market by
rigging stock information and prices.